Real options: Opportunities in the analysis of investments in logistics networks

Despite not being a new subject, the use of Real Options in the evaluation of investments in the logistic structure still presents enormous opportunities. In many cases, there is not the necessary integration between the finance and operations areas so that this methodology can be properly used to evaluate projects, in others, investment decisions are taken in inappropriate forums for this, such as S&OP executive meetings.

Unlike the traditional solution obtained with the method of valuation of cash flow discounted to present value (NPV), widely used for financial assets, the pricing of real assets must consider that uncertainties, mobilization and demobilization of capital can (and should) ) be scaled in time. Imagine the following case study:

Seeking to expand its operations to new regions, a company recently carried out a logistics network project, which indicated the opening of two new distribution centers. However, the worsening of the economic crisis brought uncertainty about the parameters used to determine future demand, which has generated great doubt about the acceptance of its products in the new regions.

Due to the tax rules and tax incentives offered, the opening of the DCs is completely independent, as each one is designed to serve a specific region. However, the marketing department is absolutely certain that if the products are accepted in one region, they will be accepted in the other as well.

The current estimate is that the chance of acceptance of the products is 50%. If this occurs, the NPV of operating cash flow (OPEX) obtained with the opening of each DC is R$100MM. If the products are not well accepted, the projected NPV is R$50MM/CD. The investment required (CAPEX) to open each DC is R$80MM. Considering a WACC of 10% pa, what would be the best recommendation? Open one, two or no CD?

The traditional solution, using the present value discounted cash flow (NPV) valuation method, indicates that CDs should not be opened, as they produce a negative NPV.

CD1 opening in year 0:

50% x (BRL 100MM – BRL 80MM) + 50% (BRL 50MM – BRL 100MM) = – BRL 5MM

CD2 opening in year 0:

50% x (BRL 100MM – BRL 80MM) + 50% (BRL 50MM – BRL 100MM) = – BRL 5MM

Result: – BRL 10MM

However, uncertainty should not be considered as a constant, especially when dealing with investment in real assets. In this case, the correct solution is to stagger the opening time of the CDs. Once the first CD is opened, there is no more uncertainty about whether or not the product will be accepted and, therefore, we have the following result:

Opening of the first CD in year 0:

50% x (BRL 100MM – BRL 80MM) + 50% x (BRL 50MM – BRL 80MM) = – BRL 5MM

Opening of the second DC in year 1, if the product has been accepted (50%):

50% x (BRL 100MM – BRL 80MM) / 1,1 = + BRL 9,09MM

Result = + BRL 4,09MM (best solution)

This is a very simple example of using Real Options, which can have much more sophisticated applications that require the use of simulation tools and decision trees. In a scenario of restricted credit and increased operating costs, such as that experienced by Brazilian companies at the moment, it is essential to improve the decision-making process to prioritize projects and correctly schedule them over time.